Factor Timing via Market Momentum

Does it work?

August 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Theoretically, investors allocate to risky stocks when bullish and defensive ones when bearish
  • A simple stock market momentum model does not validate this
  • Factor investing should be pursued across all market regimes

INTRODUCTION

There is little evidence that market timing works, but how about factor timing? We might be poor at predicting where the S&P 500 will be in three or twelve months, but should this not be easier for deciding on whether to bet on value or growth stocks?

Theoretically, investors should prefer risky stocks when the stock market is in a bull and defensive stocks in a bear market. Investors make style changes slowly, therefore we might be able to exploit such trends by measuring the momentum of the stock market. When the momentum is positive, buy cheap and small-cap stocks, when negative, buy high-quality and low-volatility stocks.

In this research article, we will exploit factor timing via stock market momentum.

U.S. FACTOR PERFORMANCE IN MARKET REGIMES

First, we evaluate the returns of five factors in the U.S. stock market by using the performance of the stock market as a signal. Long-short factor returns for the size, value, profitability, and momentum factors are sourced from the Kenneth R. French data library, while low beta factor returns are from AQR.

We create two portfolios for each factor based on the 12-month performance of the U.S. stock market, where one day delay is used for performance measurement and rebalancing occurs quarterly. One portfolio represents when the stock market performance was positive, and the other when negative. The U.S. stock market exhibited positive momentum of 77% of the days between 1964 and 2024.

We observe that the size factor generated the lowest and the low beta factor the highest CAGR over the 60 years. All factors except size generated higher returns when the stock market momentum was positive, but factor returns were even positive when the market momentum was negative, except for the momentum factor. Stated differently, factors generated almost always positive excess returns, regardless of how the stock market was performing.